Keeping Up with the Joneses: Risk Tolerance

Much has been made on the blogosphere and even on our own website about keeping up with the Joneses, the desire to maintain expenses similar to your neighbors. They bought a new Infiniti, why shouldn’t I? A similar, yet different, concept is the idea of lifestyle creep, the slow build-up of “necessary” expenses as your income increases. I myself have experience a bit of both in my career, noticing small purchases that I used to consider luxuries as being more commonplace. What I want to touch on in this article, however, is something I think is unique to the blogosphere or personal finance fanatics. I will refer to it in this article as ‘risk competition’. As a group of people who value our net worth, time and personal finance well-being there is a fair amount of healthy competition on net worth, savings rates and age of financial independence. Perhaps this competition may lead individuals to make riskier financial decisions that they are truly comfortable with.

What is your true level of risk tolerance?

Many of the other forms of competition that the personal financial blogosphere can inspire is healthy to an extent. When bloggers participate in spending holidays or saving binges it may inspire some to up their savings rate or reduce some of their unnecessary expenses. To a certain extent, this is healthy. Too much of this, however, and I would suggest that the focus is misplaced but I digress. When it comes to investment decisions, however, it becomes a more personal decision. I am not a blogger who dismisses any discussion of asset allocations with”omg! it’s a personal decision and i’m not a financial planner so do wut u feel”. I believe there is a proper asset allocation to target at certain ages and I am not shy in my own appetite for risk. I do, however, recognize that each investor’s risk tolerance is different. I do not have kids or am nearing retirement so naturally I have the capacity to take on more risk, but I also have a natural inclination to take on high-risk, high-reward opportunities (no, I have not been duped by an Ponzi schemes).

Buy now or be priced out forever!

Where this becomes an issue is when the media or good old fashioned jealousy take place. Regret is a powerful emotional tool and the media loves to exploit other people’s gains to inspire envy. When you are a renter and you see home prices jump 12% in a city, you feel a tinge of regret at your lack of housing. If you are in bonds and see flat returns as stock returns are robust (2009-present has been extremely healthy for both bonds and stocks), you see others’ returns as a loss of opportunity. This powerful emotional response may lead investors to make suboptimal decisions given their risk appetite. If I (and I presume my co-writer PK) posted our returns this year, it will probably inspire jealousy in some of our readers. That is not to say that we are excellent investors (speaking for myself here), just that I was able to bear a lot of risk which has paid out in recent years. If in the next few years there is a major market correction, I will be the first to recognize my jealousy in more conservative asset allocations.

Why does this matter to you?

The media does a fantastic job of highlighting outlying data points. The day trader who made millions. The house flipper who retired at age 28. The entrepreneur who struck it rich. Every story in its own very small way undermines the confidence of those who have different risk appetites.

“Look at all these people making millions off the stock market and here I am investing in stupid old bonds!”

Taking an honest appraisal of your own risk appetite is important to ground what your true allocation should be. Can you handle your net worth decreasing 30-40% in a single year? How soon do you actually think you need the money you are investing? Are you dependent on the income from investing on a day-to-day basis? These questions will help inform how you should really feel about those who speculate and make it rich in markets. It doesn’t make my reaction any less emotional, but at least I feel I am detached enough to make a rational decision after recognizing my own emotional response. I can only hope that as a writer, my own opinions on risk appetite and investing can inform and provide a reference point for discussion. I hope that those who have differing risk appetites from my own can see my own opinions and examples for what they are: a reference point and an example. Not a model that every single person in every single situation should follow.

Comments

There are always risks in everything we do and don’t do in life. The problem is not realizing you are taking a risk. Most people think there is always enough time to catch up on retirement savings or just enjoying life. Time is the most important advantage in investing and making good choices.

You’re also pointing out the risks of recency and sampling bias. We remember the guy who daytraded his way to millions while forgetting about the people who daytraded their way to a bankruptcy filing. The media doesn’t cover the vast majority of the sad trombone cases because they don’t sell ads; after all, they have murders and Washington, DC to provide all the negative news they need. The same holds true for startups. Everyone wants to think that they’re the next Facebook or Tumblr while being willfully blind to the statistics about the failure rate of startups.

Being risk-seeking is fine. Thinking that risk only comes with rainbows, unicorns, and bacon is a fool’s errand.